Thoughts On The Market Week Of May 16

As treasury yields continue their slow march downwards, this has implications for the ongoing budget debate in Washington, DC. The seeming agreement by both political parties on the need for long term deficit reduction shouldn’t be confused with a shared plan on how to achieve that goal.

Both sides remain far apart, with the Republicans favouring spending cuts while the Democrats prefer higher taxes. Behind all this there is little support for the substantive decisions required to close America’s spending gap. In a recent New York Times poll, 57% of respondents disapproved of the President’s handling of the budget deficit while 63% disapproved of the Republicans’ handling of the same issue. Inevitably, popular opinion is for deficit reduction as long as it doesn’t affect them.

As a result, it’s likely that the current perceived support for fiscal discipline will be revealed to be quite shallow and the tough decisions put off until after the next Presidential election.

The latest drop in treasury yields, in spite of the breaching of the Federal debt ceiling and the end of QE2, simply highlights that there are for now no meaningful costs to current policy. As long as interests rates remain so low, it’s going to be difficult to persuade the electorate that painful action is urgent. Moreover, the recent softness in 2Q economic activity renders the recovery more vulnerable to fiscal drag at the Federal level (since state and local budget pressures are already subtracting from growth).

For us, the net result is that bond yields remain unattractive, and as long as they remain low emerging market currencies continue to be an important source of yield. We have been adding to the WisdomTree Dreyfus Emerging Currency ETF  (CEW) during its current pullback caused by a strengthening US$. CEW invests in short maturity U.S. agency debt and uses FX forwards in a basket of emerging market currencies to create the economic equivalent of short dates sovereign debt exposure in local currencies. The table below shows official interest rate policy in its top 10 holdings:


Current Official Interest Rate

Last Change













South Korea












South Africa






Source: JPMorgan

Rates are of course all higher than in the U.S. and are largely moving up. In the two countries where the last move in rates was down (Mexico and South Africa) that was in July ’09 and November ’10 respectively, so they are in effect on hold. Earning interest income only seems possible outside the U.S.

Elsewhere, the commodities sell-off appears largely to be the result of contagion as commodity hedge funds reacted to losses in one market by reducing risk elsewhere. While there has been some GDP softness in the U.S., EU-zone first quarter GDP was a respectable 3.3% as Germany and France both registered good numbers. Meanwhile, China and India continue to grow at high single digit rates, and as a result it’s unlikely that their demand for commodities including crude oil has wavered much.

In fact recent weakness in crude oil is likely to be mildly simulative to developed market consumption since there’s been increasing evidence that gasoline purchases were starting to encroach on other forms of discretionary spending. Silver is probably an exception though, and the sharp jump in margin requirements that followed growing retail participation has likely cured the speculative fever that had swept prices up by over 150% in less than a year.

Figuring out the market clearing price for silver is in any case extraordinarily difficult, since changes in speculative demand are far more significant than shifts in industrial consumption or mining supply. Some of the mining stocks do appear undervalued to us though, and we continue to own Coeur d’Alene which we find discounts a much lower silver price than is currently available.

We also recently added to Aegean Marine Petroleum (ANW) which provides bunker fuel to the shipping industry. Shipping has been a miserable business lately – freight rates barely cover operating costs and new ship orders placed during better times prior to 2008 continue to add capacity to the shipping fleet faster than new demand can take it up.

Consequently, we were attracted to ANW since their business is providing fuel to the (still growing) global ship fleet. Pressure on their operating margins has depressed their profits and their stock. However, their earnings last week showed signs that perhaps the worst is behind us as revenues and profit were ahead of expectations.

In addition, they have been awarded the exclusive concession to provide fuel at both end of the Panama Canal, which they expect will increase volumes by around 3 million metric tons annually (in 2010 they shipped 10.3 million metric tons). ANW’s results are highly sensitive to margins on fuel; their gross spread had fallen as low at $16 per MT in 4Q10 before jumping to $22.40 in the recent quarter.

While we don’t expect them to return to the profit margins they enjoyed prior to last year, even a modest improvement could see them earning $0.50 a share this year and more than $1 next year when they should start to see the benefits of the Panama deal. We think the stock is an attractive investment at current levels of $9.

Disclosure: Author is Long CEW, CDE, ANW